The Commodity Investor: Depressed Natural Gas Prices Offer a Good Entry Point

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Tue, Apr 3, 2012

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Post by Amine Bouchentouf, Resource Columnist

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Columnist Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the bestselling Commodities For Dummies, published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities.

Natural gas prices are trading at historic lows, which the market has not experienced for almost ten years. In this week’s column, we take a look at the fundamentals of the natural gas market and examine the market drivers that have pushed prices to these historic lows. Based on these drivers, we can extrapolate what the market will do in the coming months, and determine the best investment strategy to generate returns within these market conditions.

Natural gas prices are currently trading at historic lows of $2.30/mmbtu. That’s a far cry from the $15/mmbtu we saw in 2006 or even the $6/mmbtu we experienced in 2010. With the demand for energy products increasing and with oil prices at near historic highs, it seems almost counterintuitive that natural gas prices are trading at these distressed levels.

However, the natural gas market is a peculiar market that is subject to unique and internal market drivers. In order to better understand why natural gas prices are so low while other energy prices are high, we have to look at the market drivers of natural gas. Specifically, natural gas supply is currently at historic highs. Inventories of natural gas, especially in North America, are at levels that we haven’t seen in over a decade, and this is one of the main reasons for the low prices.

Natural gas outlook

The natural gas industry has invested heavily in new technologies in recent years in order to improve extraction methods and introduce operational efficiencies. The industry mastered hydraulic fracking and horizontal drilling techniques that made discovering gas infinitely easier than in previous decades. In this case, the industry became a victim of its own success as improved technologies helped unlock previously undiscovered natural gas reserves throughout North America.

Specifically, shale gas field technology has added to record inventories and led to excess supplies not seen in almost 20 years. Inventories are 15 percent above their five-year average. As a result, many companies have announced drastic cuts to their capital spending for natural gas. A survey by Moody’s reveals that natural gas companies plan to cut production spending by up to 40 percent. Chesapeake (NYSE:CHK) announced that it will cut its drilling activity by 50 percent. But even with these drastic measures, the market will remain in drastic oversupply.

Another key element that’s keeping natural gas prices depressed is the weather. The winter in North America, one of the most important markets for natural gas, has been especially mild this time around, which has reduced demand for natural gas heating in households across the United States. The natural gas market is facing the perfect storm that’s keeping prices depressed at historic lows: excess oversupply and decreasing demand. Faced with this scenario, some analysts believe that natural gas prices may go negative. Although the likelihood of gas companies giving away natural gas for free is highly unlikely, this shows how drastic the situation is.

What’s an investor to do?

The Commodity Investor is constantly on the lookout for investment opportunities with an inherent market dislocation and an identifiable catalyst that can help investors unlock value and generate returns. In this case, the natural gas market caught my attention because of the stark nature of the dislocation. I believe that this market dislocation has created a unique investment opportunity for investors to generate sizable returns. At the right entry point, investors stand to make a sizable return on investment once the market turns around.

My position is that natural gas prices cannot remain depressed forever. Yes, it’s unlikely that we will see prices jump to $10/mmbtu in the next quarters, but prices will begin to trend upward as companies begin tightening their drilling activities and as consumers resume their use of natural gas. In addition, there are new demand uses for natural gas that may eventually help drain the excess inventory. Specifically, the market for natural gas vehicles (NGVs) is starting to take off, and should become an important source of demand for the industry. Already in countries like Brazil, over ten percent of cars are NGVs. And the industry is starting to take off in the US as well.

I believe that a rebound in prices will happen in the coming quarters, so it’s important to position yourself appropriately. I hold the view that beginning to accumulate shares of a select group of companies in the coming months will be rewarding down the line.

One company I recommend that’s significantly increasing its footprint in natural gas is Chevron (NYSE:CVX). Chevron has recently announced plans to spend billions of dollars building up its natural gas business, and has already made substantial investments in the Bakken area of North Dakota. In addition, since Chevron is a diversified energy company, you can hedge your natural gas exposure through crude oil, derivatives, and other products the company is a leader in.

For a more speculative play, I recommend taking a look at Atmos Energy Corp. (NYSE:ATO). Based in Dallas, Atmos is involved primarily in natural gas service derivatives, such as storage, distribution, and transmission. This is a good way to play the natural gas angle since you’re not relying on physical commodity price drivers as much as the related services. These two companies give you a hedged and prudent exposure to natural gas, and should generate good returns once prices start to recover.